Coverage of the 2014 Risk Management Conference

The world of smart beta continues to advance rapidly. And, while the wave of smart beta innovation ultimately benefits investors, it is important to emphasize that smart beta strategies are not complete investment strategies in and of themselves. Rather, they should be viewed as components of a broader portfolio, alongside traditional active and passive strategies using a process that involves design, construction, and management.

While the term “smart beta” elicits a wide range of reactions, most investors generally agree it falls somewhere between traditional active and passive strategies. Smart beta strategies introduce an active risk element by deviating from market capitalization weighting, but they retain some key features of traditional indexes, such as transparency and systematic rebalancing. Smart beta strategies have evolved significantly as index providers move beyond broad market exposure to alternative weightings and more focused factor exposures. They’ve also gained from criticism that the performance of traditional active strategies is due to systematic exposures. For example, an active value manager’s excess return may largely be a result of the value premium and not necessarily because the result of the manager picking better stocks

Investors can gain additional beta through broad market exposure and alpha through stock picking. However, the toolkit has expanded and they can now also strategically and dynamically control other systematic factor exposures with smart beta indexes.

While there are a range of strategies, the more popular smart beta approaches come in one of two forms: strategy-based or factor- based. Strategy-based smart beta uses alternative weighting schemes like equal- or fundamental-weighting; or more complex models, such as risk parity or minimum variance, to exploit market inefficiencies or anomalies. Factor-based smart beta indexes attempt to isolate specific factor exposures so that investors can manage them discretely.

Uses of smart beta

A survey on smart beta usage conducted by Russell Investments in the first quarter of 2014 shows that the three primary uses of smart beta are return enhancement, risk reduction and diversification. These results indicate that investors perceive smart beta strategies as broadly applicable, and not solely as a niche product with limited use. To that end, there are a number of use cases where investors are using smart beta indexes. While the spectrum of potential use cases is not limited to these examples, they do represent some of the more common applications of smart beta strategies:

Strategic allocations – Investors can decide to use smart beta strategies within their strategic allocations as a meaningful way to enhance returns or manage volatility. In one case, a Russell client combined a strategic allocation with a fundamentally weighted strategy to enhance returns and also made a strategic allocation to a low volatility strategy as a way to reduce risk.

Risk Management – In general, active strategies tend to increase exposure to the volatility factor. When active strategies are combined, it can cause an undesired overweight to volatility that an investor may wish to remove. Allocation to a low volatility strategy can help reduce overall exposure to the volatility factor.

Fee budget management – By providing the investor the ability to manage factor exposures directly, smart beta strategies can make better use of the investor’s active fee budget. Systematic factors can be accessed at lower cost through smart beta products, allowing more of the active fee budget to be used to compensate skillful active managers.